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How to Calculate the Discount Rate of an Ordinary Annuity

Original post by Ryan Menezes of Demand Media

An ordinary annuity issues a policy holder regular payments over time. This provides the holder with an income that's free from the tax liability of other investments. The money that the annuity eventually offers you will be worth less than the amount is worth right now. The annuity's discount rate calculates the net present value of the annuity's future payments. Economists often simply use the U.S. Treasury borrowing rate as a discount rate. You only need to calculate a separate discount rate when the rate is tied to wider economic performance.

Step 1

Subtract the U.S. Treasury borrowing rate on bonds from the stock market's expected annual percentage return. For example, if the Treasury offers a 1 percent return on bonds and the stock market is expected to offer a 5 percent return: 5 - 1 = 4 percent.

Step 2

Multiply this difference by the annuity's beta, a factor that relates its returns to general market performance. For example, if the annuity has a beta of 0.4: 0.4 × 4 = 1.6 percent.

Step 3

Add this answer to the Treasury borrowing rate: 1.6 + 1 = 2.6 percent. This is the annuity's discount rate.

                   

Resources

  • "Financial Accounting: The Impact on Decision Makers; Gary A. Porter and Curtis L. Norton; 2010
  • "Contemporary Financial Management"; R. Charles Moyer et. al.; 2008

References

  • "Balancing Environment and Development..."; Lloyd S. Dixon; 2008
  • "Corporate Finance: Linking Theory to What Companies Do"; John Graham; 2009

About the Author

Ryan Menezes is a professional writer and blogger. He has a Bachelor of Science in journalism from Boston University and has written for the American Civil Liberties Union, the marketing firm InSegment and the project management service Assembla. He is also a member of Mensa and the American Parliamentary Debate Association.

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